The
TANDEM Report
Volume 6, I s s u e 1 , J a n u a r y , 2 0 0 5
MARKET COMMENTARY:
INSIDE THIS ISSUE:
Market Commentary
1
What Drives Stocks?
1
Top 10 Holdings
2
Statistical Analysis of Composite
Stocks
3
Contact Information
6
F
or the year, the S&P 500 advanced 8.99%. Nearly all of this
gain came in the fourth quarter.
While 8.99% is a decent return, one
can’t help but observe complacency
among investors. More than eighty
percent of all S&P 500 companies reported earnings in line with or greater
than Wall Street’s expectations, and
the market has yawned.
Because earnings growth for 2004 was
strong and price gains were modest,
stocks have become relatively less expensive. Yet in spite of positive economic news, 2005 is off to a lackluster
start. Go figure.
Without question, this environment is
challenging. Good and bad news
moves individual stocks, but the mar-
ket remains rudderless. We view the
present circumstances with caution.
While we continue to like individual
stocks, the market as a whole seems a
risky place.
Volatility is a key component of our
analysis process. The volatility of a
stock is measured by its beta, which is
a calculation of a stock’s price movement predictability in relation to the
S&P 500. The S&P has a beta of 1. A
stock that enjoys a high degree of correlation to a market move has a beta
greater than 1, and a stock that moves
in a manner less predicted by a market
move has a beta of less than 1. Technology stocks, the darlings of the nineties, are typically high beta stocks.
(Continued on page 4)
MARKET SCORECARD:
S&P 500:
Annualized returns:
1 year ended 12/31/04
8.99%
3 years ended 12/31/04
1.82%
5 years ended 12/31/04
-3.78%
7 years ended 12/31/04
3.23%
10 years ended 12/31/04
10.21%
WHAT DRIVES STOCKS?
W
ouldn’t we love to know
the answer to that question? There are many theories: the war, the economy, interest
rates, tax laws, oil, the dollar, the president. But these events influence the
entire market. What causes a stock to
behave differently form the broader
market?
or down. Certain environments can be
favorable for one group of stocks, neutral to another, and detrimental to still
another. Macro events such as headline-grabbing news are difficult to anticipate, and their effects tend to be
short-term rather than trend influencing.
Without a doubt, news drives prices up
(Continued on page 2)
Many studies have been done by
TOP TEN HOLDINGS IN THE TANDEM
EQUITY COMPOSITE
AS OF DECEMBER 31, 2004
Rank by Performance of the Top Ten
Holdings in the Equity Composite for the
Period 12/31/2003 - 12/31/2004
As always, the list that follows represents our ten
largest holdings ranked by total market value in the
accounts that make up our Tandem Equity Composite. These are not recommendations for purchase. Rather, the list is simply intended to provide
some insight into how we manage accounts.
Rank by Market Value
Original Purchase
1. Home Depot
06/03/99
2. Microsoft Corp.
12/06/96
3. General Electric
07/08/94
4. Amgen
10/31/96
5. Johnson & Johnson
06/03/97
6. T. Rowe Price
03/07/97
7. General Dynamics
11/13/01
8. Allied Capital
12/21/01
9. Engineered Support Systems
01/08/04
10. Exxon Mobil
11/08/94
Company
Appreciation
Dividend
Total
Return
T. Rowe Price
31.20%
$0.78
32.84%
Exxon Mobil
25.02%
$1.06
27.61%
Johnson & Johnson
22.76%
$1.10
24.89%
Home Depot
20.43%
$0.34
21.39%
General Electric
17.82%
$0.82
20.46%
General Dynamics
15.72%
$1.40
17.27%
Microsoft
-2.37%
$3.16
9.17%
Engineered Support
7.56%
$0.06
7.66%
Amgen
3.82%
$0.00
3.82%
-7.32%
$2.28
0.86%
Allied Capital
WHAT DRIVES STOCKS ?(CONTINUED)
minds far more analytical than our own, and the
conclusions are well-documented. The response of
stocks to market-influencing events is measured by
volatility, or beta. The market is said to have a beta
of 1. A stock with a beta greater than 1 is considered more volatile than the market, and less than 1
is considered less volatile. Simply put, volatility
measures the degree to which a stock reacts beyond
what is expected by the market’s response. For a
broader discussion of beta, please refer to the Market Commentary column in this issue.
Volatility explains short-term movements around
the market. But what accounts for trends in price
over time? In an effort to better understand what
factors have a high degree of correlation with price
Page 2
trends, we analyzed the two-year performance of
those stocks currently in our composite. This is certainly not a broad sample of U.S. equities, but we
felt it sufficient for our purposes. We focused our
analysis on three variables: beta (to account for
market trends and broad events), earnings growth
and dividend growth (both of which are stock specific). The results were enlightening, but not surprising.
The sample of stocks and their relevant statistics
can be found on the page to the right. The stocks
are ranked by total return, and there appears to be
little correlation between return and the other statistics, at least to the naked eye. In an effort to de(Continued on page 5)
STATISTICAL ANALYSIS OF STOCKS CURRENTY IN OUR COMPOSITE
FOR THE PERIOD 12/31/2002 THROUGH 12/31/2004
Stock
Dividend
Growth
Beta
Earnings Per
Share Growth
Total Return
T. Rowe Price
1.51
20.00%
96.05%
133.43%
Tyco International
2.04
180.00%
10.06%
110.36%
Kensey Nash
0.73
NA
158.82%
89.00%
Home Depot
1.31
61.90%
64.10%
80.43%
Fortune Brands
0.59
17.65%
49.22%
70.97%
Engineered Support Systems
0.16
200.00%
183.33%
61.76%
American Express
1.12
31.25%
54.73%
61.56%
General Electric
1.01
13.89%
19.87%
56.43%
Exxon Mobil
0.39
15.22%
115.53%
52.55%
Biomet
0.05
66.67%
78.41%
52.27%
BP
0.59
5.73%
114.35%
51.51%
Dover
1.28
14.81%
122.12%
47.91%
Cisco Systems
2.13
NA
128.21%
47.48%
Piedmont Natural Gas
0.13
7.50%
34.74%
40.95%
Wells Fargo
0.34
69.09%
37.65%
39.77%
Allied Capital
0.65
2.24%
5.38%
39.26%
SCANA
0.26
12.31%
18.49%
36.43%
Techne
0.39
36.16%
63.74%
36.16%
Outback Steakhouse
0.77
341.67%
22.71%
35.89%
General Dynamics
0.56
16.67%
33.73%
35.14%
Amgen
0.51
NA
103.60%
32.71%
Applied Materials
2.17
NA
230.00%
31.24%
IBM
1.58
18.64%
42.28%
28.92%
Johnson & Johnson
0.18
37.50%
51.47%
37.50%
BB&T
0.37
24.55%
12.68%
20.76%
Microsoft
1.52
NA
41.30%
15.90%
Colgate-Palmolive
0.25
33.33%
16.89%
1.13%
Pfizer
0.40
34.62%
50.00%
-7.79%
0.82
55.69%
69.53%
47.10%
1.00
20.69%
55.91%
41.98%
Average
S&P 500
Page 3
MARKET COMMENTARY (CONTINUED)
ket’s move.
(Continued from page 1)
When the market moves (up or down), these high
beta stocks really move. On the other hand, defense
contractors have less correlation to the market because they tend to move for their own set of reasons. As a result, they are low beta stocks.
Most of our portfolios have a beta of about .87. This
suggests that 87% of our return is explained by the
market. We take comfort in this. As we discuss in
another article in this report, low beta does not mean
poor performance. There are other factors that drive
the price of a stock. We believe a lower beta with
strong earnings growth is a solid combination.
In a market such as this, we would rather own stocks
that move for their own set of reasons, because we
don’t have a high degree of confidence that the market will move the way
Difference in Yield between the 10-Year
we wish it to. A portfoTreasury Note and the S&P 500 Earnings Yield
lio of high beta stocks
5.00
will exaggerate the mar4.00
Bearish Territory for Stocks
ket’s move. For exam3.00
2.00
ple, if your portfolio has
1.00
an average beta of 1.5, it
0.00
Average Yield Spread
is reasonable to say that,
-1.00
-2.00
all things being equal,
Bullish Territory for Stocks
-3.00
your portfolio should
-4.00
reflect 150% of the mar-5.00
Dec-79
Dec-84
Dec-89
Dec-94
Dec-99
While we are perplexed
by a lack of response to
positive economic
trends, we recognize that
equities are still cheap
relative to other asset
classes. We are content
to own low volatility
while we watch earnings
grow.
Dec-04
TOP TEN OUT-PERFORMERS FROM THE COMPOSITE
Stock
Dividend
Growth
Beta
Earnings Per
Share Growth
Total Return
T. Rowe Price
1.51
20.00%
96.05%
133.43%
Tyco International
2.04
180.00%
10.06%
110.36%
Kensey Nash
0.73
NA
158.82%
89.00%
Home Depot
1.31
61.90%
64.10%
80.43%
Fortune Brands
0.59
17.65%
49.22%
70.97%
Engineered Support Systems
0.16
200.00%
183.33%
61.76%
American Express
1.12
31.25%
54.73%
61.56%
General Electric
1.01
13.89%
19.87%
56.43%
Exxon Mobil
0.39
15.22%
115.53%
52.55%
Biomet
0.05
66.67%
78.41%
52.27%
0.89
67.40%
83.01%
76.88%
1.00
20.69%
55.91%
41.98%
Average
S&P 500
Page 4
WHAT DRIVES STOCKS? (CONTINUED)
(Continued from page 2)
termine some correlation between statistics and
stock performance relative to the market, we decided to look at the best and worst performers.
When we narrow the list, some trends emerge. To
analyze them, we refer to the tables at the bottom of
this and the preceding pages.
First, the average beta of both groups is less than
the market. The top performers enjoy a slightly
higher beta, but one still only 87% of the market’s.
The higher beta represents a greater correlation to
the market’s movement, and the last two years have
been positive. Thus, we would expect greater performance to have a higher beta. This does not explain market out-performance, given that the average beta is still below the market’s. Dividend growth
exceeds the market’s in both groups, although the
lesser performers have a higher rate of growth.
Dividend growth more likely accounts for reduced
volatility than for out-performance. That leaves
earnings per share growth. And guess what? Earnings growth for the majority of the best performing
stocks exceeds the earnings growth of the S&P 500,
while earnings growth for most of the underperforming stocks trails the market’s earnings
growth.
Each of these factors no doubt contributes in some
way to a stock’s total return. There is no other logical explanation for a stock to out-perform the market with less-than-market earnings growth, or for
another to under-perform with stellar earnings
growth. Multiple factors are at work. But the clear
trend of each group is that earnings growth drives
stock price.
We have said it numerous times in these pages, and
this study, while less than scientific, yields the same
conclusion - earnings matter. News and current
events enjoy their fifteen minutes of fame, but in
the final analysis, few actually base long-term investment decisions on the price of oil or who the president is. We buy stocks of companies because we
believe the companies will grow. When they do, the
patient are rewarded.
BOTTOM TEN UNDER-PERFORMERS FROM THE COMPOSITE
Stock
Dividend
Growth
Beta
Earnings Per
Share Growth
Total Return
Outback Steakhouse
0.77
341.67%
22.71%
35.89%
General Dynamics
0.56
16.67%
33.73%
35.14%
Amgen
0.51
NA
103.60%
32.71%
Applied Materials
2.17
NA
230.00%
31.24%
IBM
1.58
18.64%
42.28%
28.92%
Johnson & Johnson
0.18
37.50%
51.47%
37.50%
BB&T
0.37
24.55%
12.68%
20.76%
Microsoft
1.52
NA
41.30%
15.90%
Colgate-Palmolive
0.25
33.33%
16.89%
1.13%
Pfizer
0.40
34.62%
50.00%
-7.79%
0.83
72.42%
60.57%
21.57%
1.00
20.69%
55.91%
41.98%
Average
S&P 500
Page 5
www.tandemadvisors.com
In Charlottesville:
2 Boar’s Head Place
Suite 105
Charlottesville, VA 22903
Phone: (434) 979-4300 or
(800) 527-0101
(This section intentionally left blank)
In Charleston:
901 Daniel Island Park Drive
Suite 201
Daniel Island
Charleston, SC 29492
Phone: (843) 216-3791 or
(800) 303-8316
Tandem Investment Advisors, Inc. was founded in 1990 to provide professional portfolio management with
uncompromising service to investors. For more than a decade, we have worked in Tandem with our clients to attain their investment goals. If we can provide further assistance, please contact us.
John B. Carew
Phone: (434) 979-4300
e-mail: jcarew@tandemadvisors.com
Allen Ouzts
Phone: (843) 216-3791
e-mail: caotandem@danielislandmedia.com